The VIX, a Wall Street "fear gauge" that measures volatility and was a big factor in wild stock price swings last week, is the target of a "manipulation scheme" that poses a risk to the stock market, an anonymous whistleblower told U.S. regulators.

The whistleblower, who has held senior investment positions at many of the world's largest investment firms, through a letter sent by a Washington-based law firm, urged the Securities and Exchange Commission and Commodity Futures Trading Commission "to promptly investigate the matter before investors suffer additional losses due to this fraud."

In the letter, the whistleblower alleges that market manipulators are costing investors hundreds of millions of dollars each month by taking advantage of a "pervasive flaw" in options exchange trading at Cboe Global Markets in Chicago. The flaw "allows trading firms with sophisticated algorithms to move the VIX up or down by simply posting quotes on S&P options and without needing to physically engage in any trading or deploying any capital," the whistleblower claims.

The whistleblower alleged that the recent market turmoil was partly driven by the scheme and "confirms the fraud and exposes the systemic risk to the entire equity market."

The Cboe, via a spokesperson, said the whistleblower's claims "lack credibility."

"This letter is replete with inaccurate statements, misconceptions and factual errors, including a fundamental misunderstanding of the relationship between the VIX Index, VIX futures and volatility ETPs, among other things," the statement said. "As a result of these errors, we feel the conclusionary (sic) statements contained in this letter lack credibility."

The market manipulation claim comes at a time of wild swings in markets due, in large part, to the rapid rise in VIX volatility. Many sophisticated Wall Street pros had been betting on volatility remaining low, so the quick change in market tone caused them to lose money.

The VIX, which shows the market's expectation of 30-day volatility, is increasingly used by investors to make bets on the direction of stock market volatility. The VIX is derived from S&P 500 options prices.

Up until last week, the VIX had reflected market calm by trading near record lows of around 10. But volatility began heading higher in late January before the VIX's recent explosion to the upside when it more than doubled to 37 on Monday, Feb. 5 (its biggest one-day jump ever).

The spike was partly to blame for the stock market's wild gyrations last week, when the Dow Jones industrial average fell more than 1,000 points on two separate days and the term volatility became a staple of market commentary.

That sharp spike in volatility, which the whistleblower claims was "driven largely by a rampant manipulation of the VIX index," resulted in massive losses for investors in a small number of exchange-traded products, or VIX ETPs. Those huge losses caused many of these funds to liquidate. And the resulting forced-selling caused by the sharp VIX spike exacerbated the broad market decline.

"We contend that the liquidation of the VIX ETPs last week was not due solely to flaws in the design of these products, but instead was driven largely by a rampant manipulation of the VIX index," the whistleblower alleged in the letter.

In response to the whistleblower's claims, CFTC spokeswoman Erica Richardson, said: "Complaints from whistleblowers are an integral part of the CFTC's enforcement program," the regulator said. "The Commission takes whistleblower complaints very seriously and therefore does not confirm or deny the existence of complaints, nor do we publicly comment on matters related to complaints."

The SEC declined to comment.

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The spike in the VIX, or so-called fear index, indicates that investors are becoming increasingly cautious about the strength of the long bull market, said Nick Cherney, CIO at VelocityShares.
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